A sale and leaseback example works like this: a company sells a building it owns to an investor for close to fair market value, then signs a long-term lease with that same investor and keeps operating in the building without interruption. The seller walks away from closing with cash, the buyer walks away with a tenant already in place, and the property changes hands without a moving truck ever showing up. The rest of this article works through a full numeric example, then explains what the accounting, the tax return, and the lease look like after the ink dries.
The Deal in Numbers: Apex Manufacturing and Capital Partners
Apex Manufacturing owns a production facility appraised at $25 million. The building sits on Apex’s balance sheet at a $15 million book value after years of depreciation. Apex wants to overhaul its production equipment but does not want to borrow or interrupt operations.
Apex sells the facility to Capital Partners, a REIT, for $24 million. The $1 million discount from appraised value compensates the buyer for accepting a long lease at negotiated terms. At closing, Apex receives $24 million in cash and delivers the deed. Apex is now the seller-lessee. Capital Partners is the buyer-lessor.
The master lease signed at the same closing sets the economics of the next two decades:
- Lease term of 20 years, with two five-year renewal options for a maximum occupancy of 30 years
- First-year annual rent of $1.8 million, which is 7.5% of the $24 million purchase price (the cap rate)
- Fixed 2% annual rent escalations
- Absolute triple net (NNN) structure, with Apex paying all property taxes, insurance, and maintenance on top of rent
Apex directs $15 million of the proceeds to the equipment overhaul and uses the remaining $9 million to pay down a credit line. The factory never closes.
What Apex Actually Signed Up For
The headline rent is $1.8 million, but the total occupancy cost is higher. Under absolute NNN, Apex pays property taxes, insurance premiums, and every maintenance item, including roof replacement, structural repairs, HVAC systems, and parking lot resurfacing. On a facility this size, those items can add another $400,000 to $600,000 a year depending on the property’s age and location. Capital Partners collects rent and has essentially no landlord duties.
The 2% escalation also compounds. Base rent reaches roughly $2.6 million by year 20, before NNN expenses. Over the full 20-year initial term, cumulative base rent exceeds $43 million — nearly double the $24 million cash Apex received at closing. That comparison ignores what ownership would have cost in mortgage interest, capital expenditures, and tied-up equity, but the raw number is a useful reality check.
Assignment and Sublease
The lease restricts Apex’s right to sublease or assign to a third party without Capital Partners’ written consent. Commercial leases of this type usually add that consent cannot be unreasonably withheld, and often set specific financial tests a proposed assignee must meet, such as a minimum net worth or credit rating. If Apex ever wants to consolidate into a different facility, that clause matters. Any delay or refusal from Capital Partners can leave Apex paying rent on an empty building.
Rent Escalations
A fixed escalation like Apex’s 2% gives both sides certainty but does not track real inflation. CPI-linked escalations track actual inflation instead, and can be capped with a floor and ceiling — for example, a minimum 1.5% and maximum 3.5% adjustment. In a high-inflation period, a naked 2% fixed increase can push the buyer-lessor toward renegotiation; in a low-inflation period, it can push the seller-lessee to feel overcharged.
Accounting Under ASC 842
The U.S. accounting framework for this transaction is ASC 842, issued by the Financial Accounting Standards Board. The first question ASC 842 asks is whether the deal is really a sale at all.
Does It Qualify as a Sale?
Control of the property must genuinely transfer to Capital Partners, applying the same revenue-recognition principles used under ASC 606. Control means Capital Partners can direct the property’s use, obtain substantially all remaining benefits from it, and prevent others from doing the same.
Certain protections for the seller-lessee disqualify the transaction. A fixed-price repurchase option letting Apex buy the building back at a set price would disqualify it. So would a residual value guarantee under which Apex promised Capital Partners a minimum recovery. In either case, Capital Partners does not bear genuine ownership risk, and ASC 842 treats the arrangement as a financing regardless of what the documents are called.
Gain Recognition
This is where practitioners still trained on the old ASC 840 rules get tripped up. Under ASC 842, if the sale qualifies and the terms are at fair value, Apex recognizes the full gain immediately at closing. Nothing is deferred over the lease term. FASB specifically considered deferring the gain attributable to the retained right of use and rejected that approach.
For Apex, the gain is the $24 million sale price minus the $15 million book value: $9 million, recognized in the period of closing.
Because the $24 million sale price is $1 million below the $25 million appraised value, ASC 842 requires an adjustment. The shortfall is treated as prepaid rent, and Apex’s right-of-use asset is increased by $1 million to reflect the below-market purchase price. If Apex had instead sold above fair value, the excess would be recorded as additional financing from Capital Partners — effectively a loan repaid through the rent stream.
Right-of-Use Asset and Lease Liability
After the sale, Apex records two new balance-sheet items. The lease liability equals the present value of all future lease payments, discounted at Apex’s incremental borrowing rate. The right-of-use (ROU) asset starts at the same amount, adjusted for off-market terms like the $1 million prepaid rent above. Apex amortizes the ROU asset and reduces the lease liability across the 20-year term as payments are made, similar to a loan amortization.
When the Sale Fails
If the transaction does not qualify as a sale, the consequences are ugly. Apex does not derecognize the property and does not book any gain. The $24 million cash sits on the balance sheet as a financial liability, effectively a secured loan. Apex keeps depreciating the property as if it still owned it. Each rent payment splits between interest expense and principal reduction, like a mortgage. The debt-to-equity improvement that motivated the deal disappears. This is why deal counsel spends significant time confirming the sale criteria before closing.
Tax Treatment
Tax rules run on a separate track from ASC 842 and produce their own consequences at closing and every year after.
Depreciation Recapture
Apex’s tax basis in the facility is $15 million because years of depreciation reduced it from the original cost. Under Section 1250 of the Internal Revenue Code, the portion of gain attributable to depreciation previously claimed is recaptured and taxed as ordinary income rather than at capital gains rates.1Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty For a C corporation like Apex, ordinary income and capital gains are taxed at the same 21% federal rate, so the recapture distinction is a smaller issue than it would be for an individual seller.
Rent Deductions Going Forward
Once Apex becomes a tenant, the annual lease payments are deductible as ordinary business expenses in the year they apply to, provided the amounts are reasonable and not structured as a disguised purchase.2Internal Revenue Service. Small Business Rent Expenses May Be Tax Deductible The $1.8 million first-year rent is fully deductible, partially replacing the depreciation deductions Apex lost when it stopped owning the building.
The Buyer’s Side
Capital Partners’ tax basis is the $24 million purchase price. It can depreciate the building portion (land is not depreciable) using MACRS, typically over a 39-year recovery period for commercial property.3Internal Revenue Service. Instructions for Form 4562 – Depreciation and Amortization Steady rent plus depreciation shelter is a large part of why REITs and institutional investors buy these deals.
The 30-Year Section 1031 Line
Under Section 1031, a leasehold interest of 30 years or more (including renewal options) is treated as equivalent to a fee interest for like-kind exchange purposes. If Apex’s total lease term including renewals exceeds 30 years, the IRS may recharacterize the transaction as a like-kind exchange rather than a sale, deferring the gain instead of triggering it. Apex’s 20-year initial term plus two five-year renewals totals exactly 30 years, sitting right on the boundary. Keeping the total possible term below 30 years is one of the first structuring calls tax counsel makes.
Risks That Show Up Later
Sale-leasebacks look clean at closing. The risks tend to surface years in.
Lost Appreciation
Any future increase in the property’s value belongs to Capital Partners. If the local market booms and the building doubles in value over 20 years, Apex captures none of it. A company in a growing market can find, in hindsight, that the surrendered appreciation was the single largest cost of the transaction.
Renewal Leverage
Twenty years feels long at signing, but it ends. By then Apex has installed specialized equipment, trained a local workforce, and built supply chain relationships around the site. Capital Partners knows relocation is expensive and slow, which gives the buyer-lessor real pricing power at renewal. The written renewal options in the initial lease help while they last, but once they expire, Apex negotiates from dependency.
Environmental Liability
Under the federal Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), both current and former owners and operators of a property can be held liable for contamination cleanup.4Office of the Law Revision Counsel. 42 USC 9607 – Liability CERCLA imposes strict, joint, and several liability, so either party can be forced to pay the full remediation cost regardless of who caused the contamination.
Purchase agreements and leases usually try to allocate this risk contractually: the seller indemnifies the buyer for pre-existing contamination, and the buyer takes on conditions arising after the transfer. Indemnification does not eliminate CERCLA liability. It creates a contractual right to seek reimbursement. If Apex later goes bankrupt, Capital Partners as current owner is still on the hook for cleanup. Both sides should insist on a Phase I environmental site assessment before closing, and a Phase II if the Phase I flags anything.
Transaction Costs
Closing costs cut into the seller’s net proceeds. The deal requires a purchase agreement, a master lease, estoppel certificates, and environmental indemnification agreements, plus title insurance, broker commissions, environmental assessments, and state or local transfer taxes. Transfer tax rates range from zero in some states to over 3% of the sale price in others. On a $24 million deal, total transaction costs can easily reach $1 million, with the seller typically bearing the larger share.
Structuring Points That Age Well
Whether a sale-leaseback strengthens a company or becomes a long regret usually comes down to a handful of decisions made before closing.
Get an independent appraisal before negotiating price. A sale at 90% or less of appraised value should trigger hard questions about whether the company is leaving too much value behind.
Model the total lease term against the 30-year Section 1031 threshold before the letter of intent is signed. Initial term plus every renewal option counts.
Consider CPI-linked escalations with a floor and ceiling instead of a flat fixed increase. A 1% floor and 3% ceiling gives both sides protection without leaving either exposed to a runaway inflation cycle.
Spell out maintenance obligations in granular detail. “Tenant responsible for all maintenance” reads simply in a lease summary and becomes a seven-figure argument in year 12 when the roof needs replacing. The lease should set dollar thresholds for structural repairs, define capital improvements versus routine maintenance, and state whether the landlord contributes anything to major structural work.
Build in an exit. A purchase option at fair market value (not a fixed price, which can jeopardize sale treatment under ASC 842), a right of first refusal if the buyer-lessor decides to sell, or at minimum a workable assignment right for a successor business gives Apex somewhere to go if circumstances change. Companies that sign 20-year leases without planning how to get out of them are the ones eventually paying rent on buildings they no longer need.